Factors That Influence Forex Exchange Rates

Factors That Influence Forex Exchange Rates

A country’s economic health is often determined by its forex exchange rates. The exchange rates play an important role in the level of trade of countries. This is the reason why these rates are analyzed, scrutinized and manipulated by governments. On a smaller scale, currency rates could have a very real impact on the portfolio of investors.

The main effect that rate movements have is on the trading relationships between countries. If a country has a high currency its exports become expensive and its imports cheaper within foreign markets. A low currency will make a country’s exports cost less and its imports will carry a higher cost in foreign markets. A low exchange rate will increase a country’s balance of trade, whereas a high rate will decrease it.

Determinants of Forex Exchange Rates

There are several determining factors related to exchange rates and these are all linked to the trade partnership between two countries. Exchange rates are relative in that it compares one currency to another.

Interest Rates

There is a strong correlation between forex exchange rates, inflation and interest rates. When central banks manipulate the interest rate, they influence the exchange rates and inflation. Raising the interest rate gives lenders in a certain economy a better return compared to other countries. This implies that higher interest rates will attract foreign investment which will cause the exchange rate to increase. The opposite applies if interest rates are lower which means that the exchange rates will decrease.

Inflation

Countries that have a lower inflation rate that remains consistent will show a rise in their currency value. This is due to an increase in their purchasing power opposed to other currencies. In the last five decades of the twentieth century, low inflation countries included Switzerland, Germany and Japan. Canada and the U.S. achieved low inflation much later. This indicates that countries who suffer with high inflation will experience a depreciation of their currency compared to the currencies related to their partners in trade. This is normally linked to higher interest rates.

Current Account Deficits

A current account is the difference in trade between one country and its partners in trade. It indicates the payments made between different countries for services, dividends, interest and goods. A current account deficit is indicative of a country that is spending more on its trade with other countries than what it is earning from trade. It also indicates that a country needs to borrow from a foreign source to alleviate its deficit. It shows that a country needs more forex that it obtains via export sales. It also means that there is a lack of demand for products that it sells.

The forex exchange rates of the currency in which you hold most of your investments will determine the real value of the return on your investments. There are numerous determining factors related to exchange rates that leave many experienced individuals confused. It is important that as an investor you have some idea how the value of currencies and exchange rates affect the return you achieve on your investments.